a 4-6% inflation target for the Fed
Former IMF chief economist Kenneth Rogoff, now a Harvard University professor, has advocated a 4-6% inflation target for the Fed, and ex Bank of England MPC member David Blanchflower has made similar proposals. And Professors Aizenman and Marion calculate - in a different framework - that a "moderate" inflation rate of 6% could reduce the debt/GDP ratio by 10 percentage points within four years (see "Using Inflation to Erode the US Public Debt", NBER Working Paper 15562).
Last Friday, the IMF published a paper, “Rethinking Macroeconomic Policy,” part of a series of policy papers prepared by staff of the 186 member international institution that reassesses the macroeconomic and financial policy framework in the wake of the devastating crisis.
In an internal interview, IMF chief economist, Olivier Blanchard, one of the authors answered questions:
Central banks have chosen low inflation targets, around 2%. In your paper, you argue that maybe we should revisit this target. Why?
Blanchard:"The crisis has shown that interest rates can actually hit the zero level, and when this happens it is a severe constraint on monetary policy that ties your hands during times of trouble.
As a matter of logic, higher average inflation and thus higher average nominal interest rates before the crisis would have given more room for monetary policy to be eased during the crisis and would have resulted in less deterioration of fiscal positions. What we need to think about now if whether this could justify setting a higher inflation target in the future."
IMF Survey online:Isn’t that risky?
Blanchard:"The crisis has shown that large shocks to the system can and do happen. In this crisis, they came from the financial sector, but they could come from elsewhere in the future—the effects of a pandemic on tourism and trade or the effects of a major terrorist attack on a large economic center. Maybe policymakers should therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks. To be concrete, are the net costs of inflation much higher at, say, 4% at 2%, the current target range? Is it more difficult to anchor expectations at 4% than at 2%?
At the same time, it is clear that achieving credible low inflation through central bank independence has been a historic accomplishment, especially in several emerging markets. Thus, answering these questions implies carefully revisiting the list of costs and possible benefits of inflation. Nevertheless, it is worth considering whether these costs are outweighed by the improved policy maneuverability that would be available in times of crisis from having slightly higher inflation."
Morgan Stanley says investors should take note - and buy TIPS (Treasury Inflation-Protected Securities), rather than CDS (credit default swap), if they are worried about ‘default': while hard default is inconceivable, soft default through inflation is a clear risk.
Whatever about the Fed becoming more tolerant of inflation, it's hard to envisage the European Central Bank, built on the German Bundesbank model, being prepared to loosen the levers, in the absence of much tougher Eurozone fiscal controls.
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